Unfair but balanced commentary on tax and budget policy, contemporary U.S. politics and culture, and whatever else happens to come up

Sunday, March 10, 2013

Corporate tax reform?

In an earlier post I expressed both political and substantive skepticism about the current prospects and merits of 1986-style individual income tax reform, which would feature lowering the rates in exchange for broadening the base. But there has also been much talk about doing this just in the corporate income tax. Does that have greater merit?

Let's start again with the political feasibility question, then turn to the actual merits. I am skeptical about this one's prospects as well, though not for exactly the same reasons. Starting with the partisan political environment, I actually find it plausible that House Ways and Means Chairman Camp could come to an agreement with the Obama Administration, if they were the only principals. But since they are not, the general stance of the Republican Congressional leadership is inevitably part of the equation.

But there's a bigger problem. What does the deal look like, even if they have a common vision and are prepared to deal? Taxation of the U.S. business sector is unusual, compared to that of our peer countries, because of how it is split between the corporate income and the individual income tax (the latter for partnerships, S corporations, proprietorships, and LLCs that elect to be taxed as partnerships). So if you broaden the base to pay for lower corporate rates, while keeping the rest of the tax system the same, you must either actually raise taxes in the non-corporate business sector or have the tax treatment of the same item (e.g., depreciation) differ between the sectors. Plus, disparities in how much the shareholder-level part of the corporate tax actually matters make it difficult to decide how one could be aligning everything neutrally.

Now to my skepticism about the merits. The U.S. corporate income tax is a compound beast. It contains a lot of separate elements that, in principle, we would want to tease out and treat distinctively, but we don't and in some cases can't, once we have an entity-level tax that gloms them all together.

What is the core reason for wanting to lower the corporate tax rate? The answer is global tax competition. What we have in mind here, above all, is mobile capital held by foreigners who can invest wherever they like. Under "small open economy" assumptions about their investment opportunities in the U.S. we might actually want to tax their earnings here (other than rents) at zero.

But that is only one piece of the U.S. corporate income tax base. A second is mobile capital held by U.S. individuals. They, too, can invest anywhere. But in principle, under the worldwide residence-based individual income tax, we ought to be able to require them to pay U.S. tax no matter where they invest.

In practice, this is not so easy due to the realization requirement and their ability to invest abroad through non-U.S. entities (although the passive foreign investment company or PFIC rules should catch them when they hold a foreign stock or bond portfolio through, say, a Caymans entity). But we certainly have good reason to want to apply the full U.S. rates to income that they earn through a corporate entity, including when it's a U.S. entity and/or it earns U.S.-source income. So for them we want a higher rate, but you can't have the tax rate in an entity-level corporate income tax depend on who is the owner.

Then a third element is labor income that U.S. individuals earn through corporate entities. This is the issue of owner-employees under-paying themselves, and here we definitely want to charge the full U.S. rate. But we automatically lose this, if we lower the U.S. corporate rate, unless we adopt tough associated reforms such as a Scandinavian-style "dual income tax."

So what ought the U.S. corporate rate to be? The answer is, it should be different for each of these elements, and also different depending on how we evaluate the burden of shareholder-level taxation (which may end up being zero for people who wait for basis step-up at death, but for others may be significant).

The point here is not that we definitely shouldn't lower the U.S. corporate rate, but that it's a complicated question because we should as to some elements and shouldn't as to others, yet in effect must pretend that one size fits all, at least in the absence of other changes that I don't believe are really on the table.

Now let's briefly consider the pay-fors. There is certainly some garbage in the U.S. corporate income tax base that it would be great to get rid of (although arguably the revenue gain should go to lowering the long-term U.S. fiscal gap). But consider, say, accelerated depreciation. While cost recovery disparities create inter-asset distortions, it's not all bad to have the system closer to a consumption tax rather than an income tax base, in terms of incentives for new investment. And as a transition matter, if we lower the rate and pay for it by slowing down depreciation, then to a degree we have combined a windfall gain for old investment (which deducted accelerated depreciation at a higher rate and now gets to include the associated income at a lower rate) with what is effectively anti-stimulus for new investment in the middle of a continuing jobs crisis.

About Me

I am the Wayne Perry Professor of Taxation at New York University Law School. My research mainly emphasizes tax policy, government transfers, budgetary measures, social insurance, and entitlements reform. My most recent books are (1) Decoding the U.S. Corporate Tax (2009) and (2) Taxes, Spending, and the U.S. Government's March Toward Bankruptcy (2006). My other books include Do Deficits Matter? (1997), When Rules Change: An Economic and Political Analysis of Transition Relief and Retroactivity (2000), Making Sense of Social Security Reform (2000), Who Should Pay for Medicare? (2004), Taxes, Spending, and the U.S. Government's March Towards Bankruptcy (2006), Decoding the U.S. Corporate Tax (2009), and Fixing the U.S. International Tax Rules (forthcoming). I am also the author of a novel, Getting It. I am married with two children (boys aged 24 and 21) as well as three cats. For my wife Pat's quilting blog, see Patwig’s Blog.